Vescore Global Market Outlook September 2023

Our risk model, SDRM,⁷ sticks to the comparison of the current environment with the late 1980s. However, similarities with the 2007/08 period increased slightly in August. Like March 2023, when rising banking sector stress in the US and Europe triggered the comparison, stress in the Chinese real estate market and shadow banking system contributed to the comparison this time.

What has happened? Cracks in Chinese real estate and the shadow banking industry came to the surface in August. Not only the potential Country Garden default – the company is still in the so-called grace period – made it in the headlines and undermined sentiment. But spillovers from real estate woes into the shadow banking system gained more attention as well. In this regard, suspended payments on its products by the Wealth Management arm of the privately owned Zhongzhi Group raised questions about the sustainability of real estate developers’ debt and possible contagion risks into the banking sector. However, the still small flare up suggests that our risk model attaches only a small probability to systematic banking sector stress comparable to 2007/08.

7. More information on our SDRM model can be found in “Risk Management: Forward on calm seas, adaptive and agile in stormy phases”

2023 has been a roller-coaster so far in economic terms. After a good start and broader based recovery signals, data deteriorated during the second quarter on the back of banking sector stress in developed markets and the clogged monetary policy transmission channel in China (Figure 3). While the Chinese economy keeps struggling to transmit stimulus into growth and therefore dragging emerging markets into contraction, developed countries seem to be getting back on their feet again. With 41% of processed economic time series improving, the world economy re-entered a recovery state. But as our preferred measure of global liquidity still points to tight monetary conditions, the probability of the world economy to relapse into contraction (49%) and therefore recession risks⁸ remain high. In other words, the economic recovery is on shaky ground.

Developed markets: US emerges from a technical recession

Developed markets seem to have recovered from banking sector woes in late March and re-entered a recovery state. However, from a country perspective the picture remains mixed with the Euro Zone and in particular the US (+9%-points) among the winners and Asia Centric countries such as New Zealand and Australia among the weaker countries. An in-depth analysis of the underlying indicators reveals that soft or sentiment data has been in the driver’s seat of the fresh recovery signal. After historically low readings, all countries – except for the UK and Australia – experienced rising consumer sentiment. This is surprising, considering rising real financing costs, but should be seen as a reflection of the still high consumer resilience⁹. Despite deteriorating labor market conditions in developed markets, indicators such as unemployment rates remain close to historical lows.

Emerging economies: Stronger growth momentum in LATAM and EMEA

Diverging growth trends do persist within emerging markets, with Asia (Contraction) underperforming EMEA (Recovery) and LATAM (Expansion). China remains a headwind for the Asian region. Despite monetary and fiscal policy support, Chinese data releases remain disappointing, with real estate and banking activity once again weaker after an improvement earlier this year. In addition to weaker demand from developed markets, weak private sector demand for credit makes policy stimulus less efficient. The housing market downturn, which started approximately three years ago, undermined balance sheets of corporates and households, to some extent weighing on consumption and investments.

8. Details on recession probabilities derived from our models can be found in the August edition of the GMO
9. Details on our analysis of the consumer resilience can be found in the July edition of the GMO

Our equity allocation model, GLOCAP, has reduced its equity allocation further over the last few weeks (Figure 4) after running a maximum equity allocation until late June 2023. The reduction has been driven by all four (Term Spread, Ted Spread, Credit Spread and Dividend Yield) factors. Interestingly, the reduction can be attributed to a lesser extent to changes in the indicator level, but rather to the change in underlying sensitivities. Falling sensitivities can be interpreted as a lower conviction of the model.

Two developments have undermined risk sentiment, and therefore correlations and sensitivities, lately: First, the release of disappointing economic data out of China and policy response to it. Second, investors’ rising concern that Central Banks are subject to the temptation of living with above 2% inflation, as this would be one way to deal with high government debt. The rise in Treasury issuance in an environment of higher US yields are the fertile soil of these concerns.

Our Bond allocation model, FINCA, has reduced its bond allocation since May. However, recent reduction has been driven mainly by the momentum model (see Figure 5). As yield levels are rising to more extreme levels compared to recent history, the mean reversion element of our bond allocation model is moderating the effect of the momentum element. From a country perspective, two thirds of the underweight are currently taken in US and Canadian government debt.

In addition to Investors’ concerns that Central Banks may allow higher inflation in the future in order to deal with debt burdens, the economic resilience of the US has moved recession risks to the background and therefore lowered recession risks driven flight to safety. Thereby supporting the positive yield momentum, which is currently driving the underweight. The aim of BRIC countries to decouple from the US Dollar is another longer-term subliminal trend, which however made it in the headlines again in August as the BRIC summit took place in South Africa in late August.